Magazine

U.S.: Iffy Prospects for a Strong Recovery

October 28, 2001

Is the stock market telling us something about economic prospects? After all, the broad Wilshire index of 5000 stocks is up nearly 13% from its low on Sept. 21, and historically the stock market turns up about six months before a recovery begins. Investors appear to be looking beyond the valley of a short and mild recession to a strong recovery on the other side.

So far, the mild recession part of that scenario is on target. The downturn will be limited by past rapid adjustments by businesses to inventories, capital spending, and payrolls, and by Washington's timely and aggressive policy actions. While worries about anthrax exposure will test consumer confidence, reports suggest that consumer spending in the wake of the September 11 terrorist attacks is holding up better than expected. As Federal Reserve Chairman Alan Greenspan told Congress on Oct. 17, "All in all, I think we are looking at a situation that is nowhere near as bad as many of us thought it would turn out to be."

But the strong recovery part of investors' apparent outlook is still iffy. Greenspan quickly added that the economy "is also not exhibiting a snapback which has been typical of what happens when you get a major hurricane or natural disaster which breaks down the infrastructure."

KEEP IN MIND that mild recessions have tended to be followed by mild recoveries, the most recent example being the upturn from the modest 1990-91 downturn. In contrast, severe recessions tend to engender strong recoveries, because they generate overly sharp adjustments to inventories and the balance sheets of businesses and households, and they create a backlog of pent-up demand that suddenly needs to be filled.

Consumers are the sector to watch, but the requirements for a powerful spending upturn by households is not likely to fall into place anytime soon. Throughout this business cycle, household buying has been governed by two basic factors: the labor markets and the stock market. Support from both of those sources has been eroding all year. Household net worth is set to decline again for the second year in a row (chart), and labor market weakness will extend well into the new year, eroding consumers' sense of job security.

The depth of this recession will very likely be determined by the size of the falloff in fourth-quarter gross domestic product. The initial readings do not look terribly dire, but the shock effects from the September attacks are creating some insurmountable math problems for fourth-quarter GDP. The plunge in September activity pushed many of the key measures that affect GDP to levels well below their third-quarter averages, especially consumer spending.

We now know that retail sales in September plunged 2.4% from August (chart). The only gains were on essentials, such as food, gasoline, and drugs. First of all, that means third-quarter real consumer spending, as it goes into the GDP data, appears to have risen at an annual rate of 0.5% to 1.5%, down from 2.5% in the second quarter. The lower end of that wide range incorporates a heavy hit to outlays for services, such as air travel and hotels. Given the trends in other GDP components, economic growth in the third quarter, due to be reported on Oct. 31, seems likely to have declined, probably in the range of -0.5% to -1.5%.

Second, the September sales drop means that consumer spending in the fourth quarter will post an outright decline. How large? Consider two paths: Even if outlays return to their pre-September growth rate--a very optimistic assumption--real spending will still decline at an annual rate of -0.5% to -1%. If spending stays flat at its weak September level, real outlays will fall at a rate of -2.5% to -3%.

GIVEN THAT OCTOBER SPENDING appears to have picked up, a drop in fourth-quarter GDP in the -1% to -2% range seems a reasonable outcome, against a backdrop of continued weakness in business outlays and exports and a topping out of housing activity. September housing starts rose 1.7% from August, but single-family building activity has weakened since April.

The fourth-quarter outlook could have been a lot worse. But early October data indicate that consumer confidence rebounded a little from late September, based on a University of Michigan survey. Early reports from auto dealers show surprisingly strong sales, although handsome incentives may have "borrowed" sales from future months. And in retailers' first fiscal week in October, sales rebounded somewhat, says Instinet Research Redbook.

Ultimately, consumer confidence boils down to prospects for jobs and income, and sentiment could take a hit in coming months as the jobless rate rises. True, weekly jobless claims fell after their September surge, but they remain well above the trend of 400,000 or so prior to the attacks. Even the pre-attack level was consistent with falling payrolls, and the current claims data imply that a sizable increase in the unemployment rates will grab the headlines when the Labor Dept. releases its October job report on Nov. 2.

LOOKING FURTHER OUT, consumer spending will be limited by soft labor markets and the adjustment to declining wealth. To be sure, tax rebates this year and more cuts next year will support consumer incomes, but weaker labor markets are already pressing on income growth (chart). Since the end of last year, the yearly growth of income from wages and salaries, adjusted for inflation, has faltered from 5.5% to 3.5%, and it will slow further in coming months as job losses continue.

Moreover, absent a rapid resurgence in profitability, which seems unlikely, businesses will not return to their exuberant hiring practices of recent years. With new attention to the bottom line, companies will extract all possible productivity gains from their slimmer workforces before adding people. That pattern would be similar to the recovery from the 1990-91 recession.

Another important challenge facing households is the new reality of diminished wealth. Through the second quarter, household net worth was already down $532 billion from yearend 2000, after posting a loss of $875 billion last year, according to Federal Reserve data. Based on the mid-October level of the Wilshire 5000 index, net worth is down by an estimated $1.5 trillion to $2 trillion from the end of last year. Reduced wealth means that households will feel the need to boost their savings next year, but that will leave less room for spending to rise.

Next year, look for consumer outlays to increase more in line with the pace of incomes. That means growth in the neighborhood of 3%. Compared with the go-go years of the late 1990s, when spending was climbing in excess of 5% per year, that's hardly the stuff of powerful recoveries. By James C. Cooper & Kathleen Madigan